Spring has finally sprung in the economic data, but bond bears remain in hibernation, for now.
When it comes to any possible bearish sentiment, bond market investors are currently preoccupied with estimating the neutral policy rate for central banks, and how far long-term bond yields may or may not rise. At this point, however, there has very little focus on where the slope of the yield curve will be headed. History suggests it will get a lot flatter as we head toward the first Federal Reserve rate increase at some point in 2015; and Canada's bond curve will follow suit.
When it comes to rate-hike cycles and where the bond curve will end up, it's best to think pretty flat. The past two significant rate-hike cycles in 1994 and 2004 (the 1999 hiking cycle was essentially a continuation of 1994, interrupted by the Asian currency crisis) can provide guidance. (Readers who believe in the magical powers of central bank communication to minimize these swings in bond yields may be inclined to stop reading now, but bear me out.)
In both cases, the 10-year to two-year slope of the U.S. bond curve flattened dramatically, from about 230 to 250 basis points to virtually zero. Moreover, the curve-flattening came well before the first Fed volley: 16 months before the February, 1994, rate hike and 10 months ahead of the June, 2004, episode.
Investors don't get as much advance warning from the Bank of Canada, so the Canadian yield curve does not start to flatten until six months before the first rise in the policy rate. This suggests that even if the Bank of Canada intends to match the Fed hike-for-hike next year, the U.S. yield curve will flatten about six months before the Canada curve.
As to the value of those mystic communication powers, the Canada curve provides some guidance based on the small and well-telegraphed rate cycle in 2010. The Bank of Canada hiked 75 basis points and the yield curve flattened by 140 basis points, to a rather skimpy 66 basis points. So perhaps the U.S. and Canada yield curves won't completely flatten; but with the U.S. yield curve presently at 227 basis points and Canada's at 148 basis points, there's still plenty of curve flattening ahead.
So when will the yield curve start to discount policy tightening? It may already be happening in the U.S., with the curve almost 20 basis points flatter now than it was a few weeks ago. But the Canada curve remains at a cycle high.
The yield curve remains steep because doubt persists about the strength of the economy, which is keeping yields low at the front end of the curve. On this score there is still plenty of room for growth to surprise on the upside. U.S. gross domestic product (GDP) growth forecasts are on the rise for the last three quarters of this year, after what promises to be a rather weak first-quarter showing. Economists have now pencilled in a rebound to 3.5 per cent annualized growth for the second quarter, and roughly 3 per cent for the second half of the year. The consensus may in fact be too timid about the second-quarter rebound; the sharp surge in hours worked in March suggests strong momentum heading into the second quarter, indicating growth could come in well above 4 per cent.
And for all the market's recent concern about growth slowdown in China, someone forgot to tell that to businesses. According to the March Institute for Supply Management (ISM) report on manufacturing activity, U.S. manufacturers remain decidedly upbeat. The export orders index jumped to 55.5, exceeding the 20-year trend of 53.5 – suggesting exports will contribute more than their fair share to GDP growth in the coming quarters. Reinforcing this upturn was a long list of comments from supply managers that the main impediments to growth were supply shortages and transportation snarls, due to still-troublesome weather during the month. Once those bottlenecks clear, the economic indicators should start to look even better.
With all this evidence of better activity in the U.S., which after all remains Canada's largest trading partner, why does the bond market remain so downbeat on Canada's growth prospects – and downright dismissive of a possible rate hike from the Bank of Canada until well into 2016?
It could be because growth predictions remain so dour (as if forecasters forget that the toppy housing market is only 4 per cent of GDP). Whatever the reason, consensus growth forecasts remain far below those of the U.S., at about 2.25 per cent for 2014 and 2.4 for 2015. The Bank of Canada will weigh in next week on Canada's GDP outlook, but recent commentary from bank officials suggest their forecasts will not budge much from the update last January, at 2.5 per cent for both this year and next. Given that the economic fortunes of Canada and the U.S. remain strongly intertwined – with an impressive 83 per cent correlation between Canada and U.S. GDP growth – investors should start seeing growth forecasts on this side of the border rise before too long.
Sheryl King is an independent macroeconomic strategist with more than 20 years experience in the international financial industry and central banking.